Perfect Storm Converges On Struggling Industry

All is not well in the Canadian pork industry. Producers from one end of Canada to the other are enduring losses of a magnitude not seen since the fall and winter of 1998-99. Slaughter capacity is being lost and Canadian packers are also suffering severe losses. The difference between those dire days in 1998-99 and now is that there doesn't appear to be a light at the end of the tunnel. In 1998, the

All is not well in the Canadian pork industry.

Producers from one end of Canada to the other are enduring losses of a magnitude not seen since the fall and winter of 1998-99.

Slaughter capacity is being lost and Canadian packers are also suffering severe losses.

The difference between those dire days in 1998-99 and now is that there doesn't appear to be a light at the end of the tunnel. In 1998, the problem was basically a temporary surplus of hogs.

Some are describing the situation facing the Canadian pork industry as a “perfect storm,” with various factors converging to create challenges that will test industry participants to the limits.

Exchange Rate Review

A good place to start is to review the relatively rapid appreciation of the Canadian exchange rate relative to the U.S. dollar over the past few years.

Figure 1 shows how many U.S. dollars it takes to buy one Canadian dollar. Back in 2004, it only took about 75 cents (US) to buy one Canadian dollar. As of November 2007, it took over one U.S. dollar to buy one Canadian dollar.

The impact of this currency shift is best explained by looking at how prices are discovered in Canada. As with most agricultural commodities, Canadian hog and pork prices closely follow the U.S. price because Canadian pork producers are readily able to sell to U.S. buyers. This ability results in a price arbitrage, which keeps prices in the United States and Canada closely correlated. The price arbitrage has historically been a fixture of the North American live hog and pork pricing structure.

After the U.S. hog/pork price, the next step in the Canadian price discovery process is the exchange rate. If the exchange rate appreciates, the Canadian price will decline, and vice versa. As a basic rule of thumb, for every 1% change in the exchange rate, hog prices in Canada will move by about 1% in the opposite direction.

The final part of price discovery is the “spread,” or “basis.” The most important component of the spread or basis is the cost of transportation to an alternative market or packer outside of the Canadian-producing region, such as the provinces of Ontario or Manitoba.

Currency Crunch

Movements in the exchange rate are immediately translated into changes in price. This occurs because about 85% of Canadian hogs are priced on a formula tied to a particular U.S. market or pricing structure. Therefore, the exchange rate is a key part of the pricing formula.

Figure 2 illustrates how the exchange rate impacts hog prices. The graph shows U.S. carcass prices converted into Canadian dollars (Can$). One line shows what pricing would have been like in Canada had exchange rates stayed where they were at the start of 2007 (about US$0.85). The other line shows prices based on actual exchange rates.

The graph shows by the end of the year that the appreciation this year alone cost Canadian producers about $10/cwt., carcass, or approximately $20/market hog. The most important point is that the appreciation simply trimmed top line revenues directly and rapidly, especially since the middle of 2007.

Feed Cost Challenge

Beyond the exchange rate, the most important challenge facing Canadian pork producers is the feed cost differential vs. their U.S. counterparts.

The cost of production models used at the George Morris Centre indicate that the most efficient producers in Canada face a feed cost differential of at least Can$5/head, and more likely up to $8/head. In recent months, the spread has likely been worse.

The root of the feed cost problem, of course, is higher grain pricing in Canada. Ontario is on an import basis in corn, and prairie barley pricing has been running higher than U.S. corn for the last several years.

The reasons for the feedgrain disadvantage are centered largely on the U.S. Farm Bill of 2002. Crop support programs kept feedgrain prices low and production high in the United States. As a result, Canadian crop acres and production were reduced over the years, which in turn meant that relative pricing in Canada increased compared to the United States.

Besides the higher feed costs and the shift in currency values, Canadian producers have dealt with a weakening revenue stream.

Packer Challenges

Clearly, the Canadian packing industry has been very inefficient compared to packers in the United States. A lack of economies of scale and double shifting are the biggest obstacles. These inefficiencies have left Canadian packers unable to price hogs at a level that would be more competitive with U.S. packers.

Naturally, the appreciation of the Canadian dollar has negatively impacted Canadian packers as well. Consider this example: If Canadian labor costs are $20/hour (including benefits), that translates into $15/hour labor costs in the United States, when the exchange rate is US$0.75. That looks very competitive with U.S. rates.

However, when the exchange rate is par (Can$20 = US$20), Canadian packers are not competitive with U.S. rates. Canadian operating costs were relatively competitive in U.S. dollars at a low exchange rate but, at par, remaining competitive is much more difficult.

In addition, Canadian packers are suffering from a severe labor shortage. Packers, particularly those in the western provinces, have been unable to staff their plants at rates that will allow them to operate at capacity. This, of course, means the plants are not operating as efficiently as they could. The lack of labor also prevents these packers from adding value to pork cuts, which means lost revenues and lost market share.

Figure 3 shows Canadian hog slaughter from 1997 through 2007 (estimated). As shown, total hog slaughter has been declining fairly significantly over the past three years.

Losses Take a Toll

Due to these and other factors, Canadian producers have faced severe financial stress during 2007. They have simply not been competitive compared to U.S. producers for the past few years.

According to Iowa State University data, farrow-to-finish operators in the United States likely saw about two months of losses from 2004 through September 2007. Similar data compiled at the George Morris Centre estimates that Canadian producers likely saw 19 months of losses during those same 45 months.

Debilitating losses and higher feed costs have meant more and more weaners and feeders sent south to U.S. finishers. Likewise, Canadian market hogs have moved south in larger numbers as Canadian packers close or slow their daily slaughter.

In the past, U.S. producers saw increasing exports of live hogs as a sign of Canadian advantage. Now, the increased live hog volumes are viewed as a sign of Canadian weakness.

The lack of competitiveness through the Canadian supply chain is resulting in incremental gains for the U.S. industry. Canadian pork exports to the United States are on a steady decline, while U.S. exports climb steadily upward (Figure 4). Canada still has a positive trade balance in pork, but it is slipping. During the fall of 2007, Canada became the second-largest export market for U.S. pork, surpassing Mexico. From a Canadian perspective, this is a dubious honor, but it is reflective of the Canadian pork industry's situation.

What Does the Future Hold?

Going forward, prospects for Canadian pork producers do not look promising, at least through 2008. In late December, current futures markets were suggesting that U.S. prices could average around $69/cwt. on a carcass basis in 2008. At a par exchange rate, and using typical Canadian pricing formulas, that would translate into below breakeven prices once again. In turn, this weakness has translated into decreasing sow numbers across Canada. I expect that attrition to accelerate in 2008 as producers decide to leave the business.